Benjamin Felix January 19, 2018 Advanced Investing Personal Wealth Do active managers really protect your downside? When you watch a magic act, it’s fun to be fooled. Even though we know it’s just a sleight of hand, it’s still entertaining when that torn-up card reappears out of nowhere. Active money managers want you to believe that they can act defensively to mitigate the downside of stocks during a market downturn. This is one of the ways that active managers may try convince you that index funds are too risky. No investor likes the idea of passively sitting by while their portfolio falls with the market. Investing in index funds means accepting the market through good times and bad, but active managers claim that there is a better way. Should you listen to them? In this episode of Common Sense Investing, I’m going to tell you why your active manager is not able to protect your downside. An index fund will continue to own all of the stocks in the index regardless of the external environment, meaning that when stocks are falling in value, you will continue to own them, and your portfolio will also fall in value. An active manager will claim that they can reduce your losses by making changes to the portfolio. Remember that investing is a zero sum game. If one active manager is able to beat the market during a downturn, it means that another active manager is underperforming. Most actively managed funds underperform the market over the long-term, but active managers claim that in anticipation of a downturn, they might sell some of the stocks in your portfolio to insulate you from short term losses. You can always find active managers prognosticating the next market crash, and explaining what they are doing to prepare for it. Maybe they are holding cash, or buying only certain types of stocks. If you can find an active manager that can offer protection in bad markets, that would truly be an advantage. The problem is that there is no evidence of the ability of active managers to accomplish this consistently. A 2008 white paper from Vanguard looked at active manager performance during bear markets between 1973 and 2003. Of the 11 bear markets examined in the U.S. and Europe, there were only 5 instances where more than 50% of active managers outperformed. There is no evidence that active managers, on average, have been able to produce better performance than index funds during down markets. Vanguard’s research did not stop there. The paper also showed that outperformance in one bear market had no statistical relationship to outperformance in future bear markets. This is an indication that the funds that did outperform were merely lucky as opposed to skilled. This result was corroborated in a 2009 paper by Eugene Fama and Ken French titled Luck vs. Skill in the Cross Section of Mutual Fund Returns. They found that, on average, U.S. equity mutual funds do not demonstrate evidence of manager skill. More recent research, again from Vanguard, examined the performance of flexible allocation funds in bull and bear markets between 1997 and 2016. Flexible allocation funds are able to change their allocations at will to try and time the market. During that period examined there were three bull markets and two bear markets. During bull markets, only between 31 and 36% of the funds were able to beat their benchmarks. The numbers were better in bear markets, with 65% of funds beating their benchmark in the 2000 to 2003 downturn, and 45% of funds beating their benchmark in the 2007 to 2008 downturn. While active fund performance is generally very poor on average, it appears to be slightly less poor during bear markets. The cost of active management is a heavy cost to carry for what might be a slightly greater chance at outperformance during bear markets. In the 10 years ending June 2017, only 8.89% of Canadian mutual funds investing in Canadian stocks were able to beat their benchmark index, and only 2.54% of Canadian mutual funds investing in US stocks were able to beat their benchmark index. Join me in my next video where I will revisit my mini-series on alternative investments to tell you why hedge funds don’t really hedge anything. Share: Facebook Twitter LinkedIn Email IIROC AdvisorReport
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